Neoclassical Economics: theory not law
I do not even know if my poor participation as of late should allow me post anymore but until Peter restricts my access...I will continue sharing interesting FT articles when I can.
I'm easing up on international politics because the much needed and much too late dialectic seems to finally be taking off in the US and because I want to show that I do not only think about the Middle East.
This piece touches upon the dangers of paradigms and ideological fanaticism...In my view economics should remain a social science and quit trying to be a hard science... ceteris is never quite paribus in the real world.
Enjoy the read...
Baroque fantasies of a peculiar science
By Philip Ball
Published: October 29 2006 18:48 | Last updated: October 29 2006 18:48
NB- Click ‘read more’
It is easy to mock economic theory. Any fool can see that the world of neoclassical economics, which dominates the academic field today, is a gross caricature in which every trader or company acts in the same self-interested way – rational, cool, omniscient. The theory has not foreseen a single stock market crash and has evidently failed to make the world any fairer or more pleasant.
The usual defence is that you have to start somewhere. But mainstream economists no longer consider their core theory to be a “start”. The tenets are so firmly embedded that economists who think it is time to move beyond them are cold-shouldered. It is a rigid dogma. To challenge these ideas is to invite blank stares of incomprehension – you might as well be telling a physicist that gravity does not exist.
That is disturbing because these things matter. Neoclassical idiocies persuaded many economists that market forces would create a robust post-Soviet economy in Russia (corrupt gangster economies do not exist in neoclassical theory). Neoclassical ideas favouring unfettered market forces may determine whether Britain adopts the euro, how we run our schools, hospitals and welfare system. If mainstream economic theory is fundamentally flawed, we are no better than doctors diagnosing with astrology.
Neoclassical economics asserts two things. First, in a free market, competition establishes a price equilibrium that is perfectly efficient: demand equals supply and no resources are squandered. Second, in equilibrium no one can be made better off without making someone else worse off.
The conclusions are a snug fit with rightwing convictions. So it is tempting to infer that the dominance of neoclassical theory has political origins. But while it has justified many rightwing policies, the truth goes deeper. Economics arose in the 18th century in a climate of Newtonian mechanistic science, with its belief in forces in balance. And the foundations of neoclassical theory were laid when scientists were exploring the notion of thermodynamic equilibrium. Economics borrowed wrong ideas from physics, and is now reluctant to give them up.
This error does not make neoclassical economic theory simple. Far from it. It is one of the most mathematically complicated subjects among the “sciences”, as difficult as quantum physics. That is part of the problem: it is such an elaborate contrivance that there is too much at stake to abandon it.
It is almost impossible to talk about economics today without endorsing its myths. Take the business cycle: there is no business cycle in any meaningful sense. In every other scientific discipline, a cycle is something that repeats periodically. Yet there is no absolute evidence for periodicity in economic fluctuations. Prices sometimes rise and sometimes fall. That is not a cycle; it is noise. Yet talk of cycles has led economists to hallucinate all kinds of fictitious oscillations in economic markets. Meanwhile, the Nobel-winning neoclassical theory of the so-called business cycle “explains” it by blaming events outside the market. This salvages the precious idea of equilibrium, and thus of market efficiency. Analysts talk of market “corrections”, as though there is some ideal state that it is trying to attain. But in reality the market is intrinsically prone to leap and lurch.
One can go through economic theory systematically demolishing all the cherished principles that students learn: the Phillips curve relating unemployment and inflation, the efficient market hypothesis, even the classic X-shaped intersections of supply and demand curves. Paul Ormerod, author of The Death of Economics, argues that one of the most limiting assumptions of neoclassical theory is that agent behaviour is fixed: people in markets pursue a single goal regardless of what others do. The only way one person can influence another’s choices is via the indirect effect of trading on prices. Yet it is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.
There are ways of dealing with the variety and irrationality of real agents in economic theory. But not in mainstream economics journals, because the models defy neoclassical assumptions.
There is no other “science” in such a peculiar state. A demonstrably false conceptual core is sustained by inertia alone. This core, “the Citadel”, remains impregnable while its adherents fashion an increasingly baroque fantasy. As Alan Kirman, a progressive economist, said: “No amount of attention to the walls will prevent the Citadel from being empty.”
The writer is consultant editor of Nature and the author of Critical Mass (Heinemann)
Copyright The Financial Times Limited 2006
I'm easing up on international politics because the much needed and much too late dialectic seems to finally be taking off in the US and because I want to show that I do not only think about the Middle East.
This piece touches upon the dangers of paradigms and ideological fanaticism...In my view economics should remain a social science and quit trying to be a hard science... ceteris is never quite paribus in the real world.
Enjoy the read...
Baroque fantasies of a peculiar science
By Philip Ball
Published: October 29 2006 18:48 | Last updated: October 29 2006 18:48
NB- Click ‘read more’
It is easy to mock economic theory. Any fool can see that the world of neoclassical economics, which dominates the academic field today, is a gross caricature in which every trader or company acts in the same self-interested way – rational, cool, omniscient. The theory has not foreseen a single stock market crash and has evidently failed to make the world any fairer or more pleasant.
The usual defence is that you have to start somewhere. But mainstream economists no longer consider their core theory to be a “start”. The tenets are so firmly embedded that economists who think it is time to move beyond them are cold-shouldered. It is a rigid dogma. To challenge these ideas is to invite blank stares of incomprehension – you might as well be telling a physicist that gravity does not exist.
That is disturbing because these things matter. Neoclassical idiocies persuaded many economists that market forces would create a robust post-Soviet economy in Russia (corrupt gangster economies do not exist in neoclassical theory). Neoclassical ideas favouring unfettered market forces may determine whether Britain adopts the euro, how we run our schools, hospitals and welfare system. If mainstream economic theory is fundamentally flawed, we are no better than doctors diagnosing with astrology.
Neoclassical economics asserts two things. First, in a free market, competition establishes a price equilibrium that is perfectly efficient: demand equals supply and no resources are squandered. Second, in equilibrium no one can be made better off without making someone else worse off.
The conclusions are a snug fit with rightwing convictions. So it is tempting to infer that the dominance of neoclassical theory has political origins. But while it has justified many rightwing policies, the truth goes deeper. Economics arose in the 18th century in a climate of Newtonian mechanistic science, with its belief in forces in balance. And the foundations of neoclassical theory were laid when scientists were exploring the notion of thermodynamic equilibrium. Economics borrowed wrong ideas from physics, and is now reluctant to give them up.
This error does not make neoclassical economic theory simple. Far from it. It is one of the most mathematically complicated subjects among the “sciences”, as difficult as quantum physics. That is part of the problem: it is such an elaborate contrivance that there is too much at stake to abandon it.
It is almost impossible to talk about economics today without endorsing its myths. Take the business cycle: there is no business cycle in any meaningful sense. In every other scientific discipline, a cycle is something that repeats periodically. Yet there is no absolute evidence for periodicity in economic fluctuations. Prices sometimes rise and sometimes fall. That is not a cycle; it is noise. Yet talk of cycles has led economists to hallucinate all kinds of fictitious oscillations in economic markets. Meanwhile, the Nobel-winning neoclassical theory of the so-called business cycle “explains” it by blaming events outside the market. This salvages the precious idea of equilibrium, and thus of market efficiency. Analysts talk of market “corrections”, as though there is some ideal state that it is trying to attain. But in reality the market is intrinsically prone to leap and lurch.
One can go through economic theory systematically demolishing all the cherished principles that students learn: the Phillips curve relating unemployment and inflation, the efficient market hypothesis, even the classic X-shaped intersections of supply and demand curves. Paul Ormerod, author of The Death of Economics, argues that one of the most limiting assumptions of neoclassical theory is that agent behaviour is fixed: people in markets pursue a single goal regardless of what others do. The only way one person can influence another’s choices is via the indirect effect of trading on prices. Yet it is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.
There are ways of dealing with the variety and irrationality of real agents in economic theory. But not in mainstream economics journals, because the models defy neoclassical assumptions.
There is no other “science” in such a peculiar state. A demonstrably false conceptual core is sustained by inertia alone. This core, “the Citadel”, remains impregnable while its adherents fashion an increasingly baroque fantasy. As Alan Kirman, a progressive economist, said: “No amount of attention to the walls will prevent the Citadel from being empty.”
The writer is consultant editor of Nature and the author of Critical Mass (Heinemann)
Copyright The Financial Times Limited 2006
posted by Germain at 22:37
8 Comments:
There are serious slips of fact and principle in this article. One example is that the Phillips Curve is recited as an implication of neoclassical economics. In fact, it's a Keynesian principle debunked by folks like Arthur Laffer and Milton Friedman in the 1970s. In the South we have a saying: never let the facts get in the way of a good story.
Not sure that saying's exclusive to the South, Kev.
My sense of the arguments around economics is that the science frequently fails to take account of irrational behaviour and important gaps in information. There was a good article in the Economist not too long ago about irrationality (summed up as: would you rather do a day's work or a half day's work for the same reward? No-brainer... but would you rather do a half day's work now or a day's work in a month's time - most people choose to put it off) which I shall hunt down the link to shortly.
Regarding information, a prime example would be climate change. Yesterday Sir Nick Stern called it the largest market failure in history - or at least it will be if we don't do something about it. For such a massively complex problem, it doesn't seem feasible that a purely market-based system would adequately cope. It has needed a large and belated effort by government simply to gather and communicate the necessary information, and it will require an effort many orders of magnitude greater in order to reduce the effects to manageable proportions.
BTW, I can't quite get my head around the clash between the European preference for cap and trade and the US government's focus on technology. Surely cap and trade is a system designed to incentivise technological (and other forms of) innovation? The end product has to be the same... Also, I have faith in technology and other innovations to bring about the necessary changes. I'd be quite happy to order my groceries online - the technology's already there, we'll just need an increased capacity to do so. Having said that, I don't drive so I haven't got all attached to driving out of town to the supermarket (but who would get attached to that?).
Actually the Phillips Curve was first developed by a neoclassical economist in the 20s, Irving Fisher, "one of the earliest American neoclassical economists" ( wiki Phillips Curve and then link to Irving Fisher) but we shouldn't let facts get into the way of a good critique as we say in Paris.
The paradox is that Kevin's comment confirms the article’s argument that critiques of neoclassical economics are not tolerated.
On a more constructive note, Peter is correct. Economists frequently assume a world of rational actors. Though such thinking pleases the ego, in truth we are probably more of 'part-time rational actors’ at best.
Climate change and underdevelopment are both market failures. By largely overlooking these elements, the market sacrifices long-term viability for short-term gain. I think a silly economist once said something along the lines of "the long-term does not exist." Such a view is responsible for the fact that we have frequently waiting for problems to arise before finding solutions. Were we to be fully rational it is likely that we would anticipate the future and recognize the importance of the long-term.
As for cap and trade vs technology, you are right, they are complementary and mutually re-enforcing. To me the clash between the preferences is more political in nature. By imposing cap and trade the EU hopes to spur R&D by regulating while in the US the view is that government should not constrain companies but only encourage them to increase R&D. We return again to market failure, the long-term viability of the planet is not incentive enough for companies to invest in clean technologies...enter government regulation to set some of these absurdities straight. Good thing the US has people like Schwarzenegger to set things straight!
Regardless of whether there were earlier intonations about the relationship represented by the Phillips Curve from a neo-classical economist, the Phillips Curve itself is not an implication of neo-classical economics. It was debunked by monetarists and neo-classical economists, which would mean even if it EVER had been an implication of neo-classical economics (which it wasn't), it would not now be. Oddly enough, Wiki's own articles about the Phillips Curve, Keynesian economics, and neo-Keynesianism will complicate your assertion.
As for the assertion of the reign of neo-classical economics, actually the neo-classical synthesis is the regnant theory -- that is, an odd melding of Keynesian economics and neo-classical economics.
Why is it so hard to believe that Ball just gets these things wrong? Why bend over backwards to defend him? He is, after all, a chemist and physicist and the editor of a science journal. Would it be hard to believe that if I held forth in FT on matters of chemistry that I might get some rather basic things wrong?
Now, there's a little problem for the G-man at the bottom of his post in that his assertion that government can step in and set things straight assumes precisely the same things he criticizes economists for assuming. That is, he assumes government agents will be rational and devise rational policies and implement them rationally (thus their ability to set absurdities straight). There's an awful lot of irrational legislators who devise absurd government policy and even when they do well the policies are implemented irrationally. Follow your idea through and you may countenance a bit more regulatory humility.
If we really want to wade into the deep end, we could interrogate the assumptions that underlie the pride of place given to "long-term viability of the planet". That we should pursue the "long-term viability of the planet" is a moral claim founded on additional moral claims. It's one with which I agree (so don't take me wrong here), but it is a moral claim. If it were merely an instinct about which we don't have any choice (preservation of the species), then we wouldn't need any encouragement to do it. In fact, we wouldn't be able to help doing it.
Kevin, I find amusing that you think my correction of your misinformed criticism regarding the Phillips curve is me bending over backwards to defend Ball...
You're right, government can make terribly irrational policy but it can also correct the absurdities of the market...the school system is a good example, health care is another one, and I would never claim that the policies responsible for such systems or those implementing them are perfect but I would claim that we are better off with these imperfect systems than without them, thus government regulation can correct the absurdities of the market even if these corrections engender other (different) absurdities. I know it is hard to accept that things and people can be quite complex and nuanced; it is much easier to assume that people you disagree with don’t ‘follow [their] idea through'
We do have an instinct to preserve the species but I am not afraid to admit that we have imperfect and contradictory evidence founded on paradigms which can misdirect the actions driven by our instincts...but if we pay a bit of attention to our 'rational' selves we will see that the world is changing and that perhaps it is worth minimizing our impact on this change...now you can qualify that as a moral, political, scientific, or a morally political scientific claim, I really do not care what label you give it. I do not even know why the possibility that it is a moral claim is an issue.
PS- Just got out of "An Inconvenient Truth", which Kevin is likely to have countless objections lined up for. To save myself the frustration of another unproductive argument I will just say that it was quite powerful and I suggest that people go see the film and take from it what they want.
Actually, as I showed, my criticism of Ball was correct. The author's lack of basic (let alone nuanced) understanding of economics is what caused him to think (mistakenly) that there is one theory of economics at work today (neoclassical) when there are more, and that the Phillips Curve is an implication "cherished" by that one theory, which it is not. Now, it's true that there is a dominant theory, but it's called the neoclassical sythesis and is different in important respects from neoclassical economics.
On rationality, I think perhaps I was misunderstood. My concern was that your argument assumed the very thing you criticized the economists for assuming, namely that humans will behave rationally. Which is to say the argument doesn't work. The complaints against economies (groups of humans) are likewise complaints against governments (groups of humans) and the argument has gone nowhere.
In the previous post, there's a new argument that we're better off with the government systems than without, and that because we're better off with them means they can correct market absurdities. Well, two worries: 1. that doesn't logically follow; it could simultaneously be the case that the large programs do/do not correct the absurdities of the market and that we're better/worse off with the programs and 2. you seem to be wedding your support of governmental intervention in the market to empirical claims? That is, if empirical studies indicate more people are worse off under the rule of any particular program, does that mean you no longer support its existence? Or is it a matter of principle for you that government should alter outcomes produced by markets?
When you make an argument which either uses the word "should" or "ought" or some combination of words that are analytic equivalents of those words, then ordinarily you have made a moral argument. You asserted that we should (while avoiding that word) minimize our impact on the changing world. There's nothing wrong with making a moral claim, but we need first to recognize it as such so that we may understand that it is a question of practical reason rather than theoretical reason and judge it according to the appropriate standards. The reason it's important is because you have previously suggested the lack of intersubjectivity of morality, and yet your claim here seems to depend on precisely that. What gives?
As for Al Gore's schlock, oy vey! Go see Borat instead.
Okay, okay, I've been reprimanded before for not being constructive enough in my critiques. So here goes:
While I do not agree that the assumption of rationality is the problem for economics, I do agree that there is a problem associated with rationality. Namely, the definition of that word as used by economists, realists (in IR), and rational-choice types seems to be a radically impoverished notion that rationality just means a crude self interest of increasing material possession or power.
It seems to me that rationality/reason is much more than that. For example, the aforementioned theories can't account well for altruism or sacrifice except by a cynical appeal to emotional satisfaction. That description doesn't resonate with ordinary experiences of generosity, which may feel terribly unpleasant when one forgoes something greatly desired in order to help someone else one judges in greater need. This is the same flaw most non-cognitivist or emotivist meta-ethical systems suffer -- they dissolve as soon as one is able to say honestly that I should do X and I do not want to do X or enjoy doing X, but I will do X anyway.
Rationality is surely linked to our ability to discern what material things will benefit our present condition, but it also includes our senses of basic justice and a hierarchy of good things.
So what you're saying is that current economic theory does not incorporate an accurate model of human behaviour. Your example is altruism; I think the argument applies equally to straightforward wrong decision making based on a lack of understanding or information.
I guess a key question is whether deviations from the human behaviour assumed by the economic model end up cancelling each other out somehow, which would render the model's predictions accurate.
Nonetheless I still think that in the case of climate change in particular, the complexity and particularly the scale of the problem means that we can't hope for business as usual to generate a solution within the small amount of time available. People recognise that industry is the solution; it's a question of finding the best means to goad businesses into innovating our way to a carbon neutral economy (and sustainable development in China, India, Africa...).
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